The product cycle theory identified income and cost levels of would-be-host countries as the key factors affecting firms’ ability to expand internationally. Work conducted by a group of Scandinavian researchers at Uppsala University, however, questioned the explanatory power of the product cycle theory by emphasising the limited knowledge of the individual investing firm as the most significant determinant.

In examining the increasing outward involvement of four Swedish organizations, Johanson and Wiedersheim-Paul (1975) identified a fourstage sequence leading to international production. Firms begin by serving the domestic market, then foreign markets are penetrated through exports. After some time, sales outlets are established abroad until, finally, foreign production facilities are set up. Johanson and Vahlne (1977) qualified the underlying logic of this sequential internationalization process, arguing that this stepwise, evolutionary development is based on the gradual acquisition of knowledge of the foreign market, and use of foreign-based sources ofintelligence. It is this process of incremental, experiential learning that justifies and determines successively greater levels of commitment to foreign markets.

Research at Uppsala also observed that the typical FDI pattern of Swedish firms was that they first set up foreign production facilities in one of the closest Nordic countries, such as Norway. Later on, they established subsidiaries in countries such as Germany, Holland and the UK. And only then, if still successful, they would venture into ‘psychically distant’ markets.

Although the concept of ‘psychic distance’ can be traced back to the mid-1950s (see Beckermann, 1956), its use in this context was operationalized in terms of uncertainty about would-be-host markets due to differences in culture, language and levels of education and economic development. Some studies have confirmed the existence of a gradual process characterisingfirms’ international expansion (see, for example, Yoshihara, 1978), while others have provided support to the idea that psychic distance makes firms shy away from full-ownership foreign involvement (Gatignon and Anderson, 1988). Kogut and Singh (1988) also showed that firms are more likely to choose a joint venture (Jv) entry mode over wholly owned subsidiaries as means of reducing their uncertainty in relation to investments in psychically distant markets.

The Uppsala model, however, has not escaped criticism. Millington and Bayliss (1990), for example, found that the postulated stepwise development did not reflect the actual internationalization process of UK companies expanding in the European Community (EC). This was because knowledge based on experiential learning could be leveraged and translated across countries and product markets, and these economies of scope allowed firms to bypass some or all of the intermediate stages of the postulated sequential process. Like the product cycle theory, the Uppsala model is also incapable of explaining the emerging phenomenon of firms that are ‘born global’. These are small to medium-sized companies which rather than slowly building their way into foreign markets, almost from inception expand by investing overseas.

This is often evident in operations whose market entry strategy is driven by franchising, and the investment element is exemplified in their having to establish wholly owned subsidiaries in the overseas markets as a prelude to franchising in other markets. According to an Australian report by McKinsey& Co. (1993) 80 per cent of the firms studied ‘view the world as their marketplacefrom the outset’ (p. 9). McDougall, Shane and Oviatt (1994) also found that none of the 241 firms in their sample pursued a gradual incremental process when going international. It is important to note that, much, if not all, of the literature treating the ‘born global’ phenomenon has thus far focused on the activities undertaken by such firms in developed markets, particularly within new industries and high-technology-based sectors.

The product cycle hypothesis (Kuznetz, 1953; Posner, 1961; Vernon, 1966) postulates that an innovation may emerge as a developed country export, extend its life cycle by being produced in more favourable foreign locations during its maturing phase and ultimately, once standardized, become a developing country export (developed country import). FDI, therefore, occurs when, as the product matures and competition becomes fierce, the innovator decides to shift production in developing countries because lower factor costs make this advantageous. Vernon’s (1966) model of the product cycle was primarily intended to explain the expansion of US MNEs in Europe after the Second World War and, at the time of its inception, could account for the high concentration of innovations in, and technological superiority of, the USA.

Although during the late 1960s and early 1970s a number of empirical studies provided results consistent with the hypothesis’ insightful description of the dynamic process of product development, the model is now regarded by many as largely anachronistic. First, as acknowledged by Vernon (1979) himself, the technological gap between the USA and other regions of the world (most notably Europe and Japan) has been eroded. Second, the product life extension which characterizes the maturity phase is difficult to reconcile with MNEs’ tendency to produce the new product where factor costs are at their lowest from the start, and opt for a simultaneous introduction phase of the product worldwide. Most importantly, the hypothesis appears to be at odds with the fact that most FDI flows have been, and continue to be, between developed countries. Indeed, rather than moving toward truly global production relations, available evidence suggests a tendency toward a regionalization of international production primarily concentrated within the three major regional blocks of the ‘Triad’ (the USA, the EU and Japan).

If these trends of intra-regional growth in FDI persist, we are likely to witness a further consolidation of the Triad members. The extent to which similar regional dynamics will emerge in the developing world largely depends upon the ability of developing countries to both close the gap on more advanced industrial economies (Kozul-Wright and Rowthorn, 1998), and cement regional cooperation with neighbouring countries.

The industrial organization approach (Hymer, 1960) is based on the ideathat due to structural market imperfections, some firms enjoy advantagesvis-à-vis competitors. These advantages (including brand name, patents,superior technology, organizational know-how and managerial skills) allowsuch firms to obtain rents in foreign markets that more than compensate forthe inevitable initial disadvantages (for example, inferior market knowledge)to be experienced when competing with local firms within the alienenvironment. Firms, therefore, invest abroad to capitalize on such advantages.Hymer (1970) also argued that this conduct by firms, which oftenresults in ‘swallowing up’ competition, affects market structure and allowsMNEs to exploit monopoly and oligopoly powers.

The industrial organization hypothesis has received some support in subsequentliterature. Graham and Krugman (1989), for example, used it toexplain the growing inflow of FDI in the US post-1975, given the concomitantdecline of US technological and managerial superiority over thatperiod. The hypothesis, however, is not altogether cogent. More specifically,it fails to explain why firms need to engage in FDI to capitalize on theiradvantages when cheaper forms of expansion (for example, exporting)would allow them to compete equally successfully in international markets.

The offensive and defensive strategies of firms operating within imperfectmarkets have also been examined by Knickerbocker (1973). He concludedthat it is the interdependence, rivalry and uncertainty inherent in the natureof oligopolies that explains the observed clustering of FDI in such industries.Higher industrial concentration causes increased oligopolistic reaction inthe form of FDI except at very high levels, where an equilibrium is reachedto avoid the overcrowding of a host country market.

InternalizationThe market imperfection approach was further extended by Buckley andCasson (1976), who focused on the gains from internalization available in the presence of market failures. Internalization entails the acquisition of control, through vertical integration, over activities that would otherwise be carried out inefficiently through market transactions. Buckley and Casson (1976) identified several types of market imperfections, such as time lags and transactioncosts, that call for internalization, and listed a number of markets where such imperfections were more likely to be present. According to Buckley and Casson (1976), it is the internalization of markets across national boundaries that explains the very existence of international production.

Since the inception of the internalization hypothesis, much debate has taken place over the question of whether we are, in fact, in the presence of a ‘general theory’. By focusing primarily, if not exclusively, upon the firm’s motivation for producing abroad (hence partly neglecting the host country’s macroeconomic factors that may affect a country’s propensity to attract inward investment) the internalization approach should at best be referred to as a ‘general theory’ of the MNE rather than of FDI. While, at the theoretical level, the comprehensive treatment of the relationship between knowledge, market imperfections and the internalization of markets for intermediate products offered by the hypothesis has received much support, due to its high degree of generality, no direct empirical tests have been conducted.

Until the 1960s, FDI was largely assumed to exist as a result of internationaldifferences in rates of return on capital investment, with capital movingacross countries in search of higher rates of return. Although the hypothesisappeared to be consistent with the pattern of FDI flows recorded in the1950s (when many US MNEs obtained higher returns from their Europeaninvestments), its explanatory power declined a decade later when US investmentin Europe continued to rise in spite of higher rates of return registeredfor US domestic investment (Hufbauer, 1975). The implicit assumption of asingle rate of return across industries, and the implication that bilateral FDIflows between two countries could not occur, also made the hypothesis theoreticallyunconvincing.

Portfolio diversification

The search for an alternative explanation of FDI soon revolved around theapplication of Markowitz and Tobin’s portfolio diversification theory. Thisapproach contends that in making investment decisions MNEs consider notonly the rate of return but also the risk involved. Since the returns to be earnedin different foreign markets are unlikely to be correlated, the internationaldiversification of an MNE’s investment portfolio would reduce the overall riskof the investor. Empirical studies have offered only weak support for thishypothesis. This is not surprising when one considers the failure of the modelto explain the observed differences between industries’ propensities to investoverseas, and to account for the fact that many MNEs’ investment portfoliostend to be clustered in markets with highly correlated expected returns.

Market size

The market size hypothesis, which has its roots in neoclassical investmenttheory, focuses on the role of both the absolute size of the host country’smarket and its growth rate. The hypothesis states that the larger the market,the more efficient the investors’ utilization of resources will be and, consequently,the greater their potential to lower production costs through theexploitation of scale economies. In his survey of earlier work on the determinantsof FDI, Agarwal (1980) found the size of the host country’s marketto be one of the most popular factors influencing a country’s propensity toattract inward investment, and most of the subsequent empirical literaturehas provided further support to the market size hypothesis (see, amongothers, Tsai, 1994; Billington, 1999; Chakrabarti, 2001).

Generally speaking, the concept of FDI refers to the setting up of an overseasoperation (greenfield investment) or the acquisition of an existing enterpriselocated within another economy. FDI implies that the investor exertsa significant degree of influence on the management of the enterprise residentin the host country. The management dimension is what distinguishesFDI from other forms of investment such as foreign portfolio investment(FPI), which includes equity and debt securities, and financial derivatives.A closer look at the concept of FDI, however, reveals that, partly due tothe complex nature of this phenomenon, its definition has changed considerablyover time. One of the earliest definitions can be found in the 1937inward investment survey conducted by the US Department of Commerce,which aimed to measure ‘all foreign equity interests in those American corporationsor enterprises which are controlled by a person or group of persons…domiciled in a foreign country’ (US Department of Commerce, 1937,p. 10). No specific definition of ‘control’ was provided in this report,although control was the main criterion for the foreign inward investmentclassification. In the subsequent survey of outward investment, ‘the UnitedStates equity in controlled foreign business enterprises’ (US Department ofCommerce, 1953, p. 4), control was explicitly defined on the basis of fourinvestment categories, only some of which would still constitute measuresof FDI.

As noted by Lipsey (1999), the current definition of FDI, as endorsed bythe IMF (1993) and the OECD (1996), seems to have shifted its emphasisaway from the idea of ‘control’, toward a ‘much vaguer concept’ (Lipsey,1999, p. 310) of ‘lasting interest’. According to this new benchmark definition,FDI ‘reflects the objective of obtaining a lasting interest by a residententity in one country (“direct investor”) in an entity resident in an economyother than that of the investor (“direct investment enterprise”). Thelasting interest implies the existence of a long-term relationship between thedirect investor and the enterprise and a significant degree of influence onthe management of the enterprise’ (OECD, 1996, pp. 7–8).

In spite of the efforts of international agencies to push for uniformity, itis important to acknowledge that definitions and measurements of FDIstill differ among countries. Indeed, different countries often have diverse conventions as to what constitutes ownership of a company from the pointof view of the management of its assets. For example, while in the USA anequity capital stake of 10 per cent of shares would suffice to indicate foreignownership, in the UK a stake of 20 per cent or more would be regarded as amore appropriate indicative threshold. Most importantly, there are seriouspractical difficulties in the compilation of FDI data, particularly in the caseof developing countries which often lack the necessary technology and systemsto collect such data on a systematic basis. For this reason, evenUNCTAD’s World Investment Reports often contain statistics derived throughthe use of proxies. It is due to this kind of problem that published FDI statisticsof most countries, but particularly the developing ones, are subject toconsiderable errors and omissions. This also explains why reported data onFDI inflows and outflows, that should theoretically be equal to each other,always tend to show discrepancies.

Foreign Direct Investment (FDI) has long been a subject of interest. Thisinterest has been renewed in recent years due to the strong expansion ofworld FDI flows recorded since the 1980s, an expansion that has made FDIeven more important than trade as a vehicle for international economicintegration. Given this fact, it should come as no surprise that a large numberof theoretical explanations as to the very existence of FDI have beenadvanced over the years, with many studies focusing on the investigation ofthe determinants of such investment. However, despite the abundance ofresearch, there is at present no universally accepted model of FDI, there isstill some confusion over what are the key factors capable of explaining acountry’s propensity to attract investment by multinational enterprises(MNEs) and it is not yet clear how globalization is likely to influence thedeterminants of, and motivations for, FDI. These unresolved issues are ofspecial importance to developing countries that now more than ever seek toattract FDI to fuel economic growth.